Saturday, January 15, 2011

Drawdowns: Treacherous Statistics


“The market has symmetry: what can predictably lose you money should, if you do the opposite, make you profit.” – Clem Chambers

“A good trading system or strategy is absolutely worthless without a method of managing your money Your number one goal as… a trader is to preserve your capital so that you can stay alive long enough to have some big winners that cover the costs of your losing trades and make a profit. You accomplish this through a sound money management strategy.” – Craig Ferguson


“To make losses is human,” says Stefan Salomon without mincing words. We all need to recognize that the one thing none of us can escape in trading is loss. Accept this truth early in your career and things will improve by leaps and bounds. Try to avoid loss and inevitably, your actions will result in misery. I’ve always said that losses don’t matter as long as their average is smaller than the average derived from profits. Top traders know this and recognize the fact, but rookie traders think otherwise. This article was written so that you can appreciate drawdowns better and develop normal attitude towards them - something that matters in your personal evolution as a trader. Please see some trading strategy results below.

Portfolio Development Period (July 1, 2002 – June 27, 2008)

Trading style: Swing trading

Parameter: Long and short positions

Initial stop: 20%

Starting Capital: $100,000

Ending capital: $1,448,715

Net profit: 1348.72%

Annualized gain: 52.20%

Exposure: 39.7%

Number of trades: 1342

Average profit/loss %: 2.04%

Average bars held: 4.93

Winning trades %: 63.79%

Average profit: 6.43%

Average loss: -5.69%

Maximum drawdown: -16.35%

Profit factor: 1.79

Faik Giese (a swing trading maverick and funds manager) is the one who presented the candid results above in one of his articles. The lesson is straightforward: a good trading system will intermittently experience drawdowns, but will recover ultimately. It also means that part of the accumulated profit would sometimes be given away. You may’ve observed that as good as the portfolio performance above is, it has losing trades and periods of considerable drawdown. You may check the average loss and maximum drawdown again. There were losing months, plus some years were better than others. It’s also noted that the wider the Stop, the larger the annual returns, but the tighter the Stop, the smaller the annual returns (whereas tighter Stop reduces the exposure of the portfolio). The tighter the Stop, the higher the number of trades, and vice versa. The tighter the Stop, the lesser the trading accuracy while a wider Stop brings more accuracy (but lesser accuracy also brings good results). A tighter Stop brings higher drawdown whereas a wider Stop brings smaller drawdown. The same trading system exemplified above, coupled with the initial Stop of 5%, has a maximum drawdown of -20.01%, annualized gain of 29.63%, net profit of 373.86%, and average winning trades of 49.47%. This is still a good result which recovered irrespective of drawdwons. Trading rookies and impatient traders may conclude that a trading system is bad during a losing month and a period of drawdown. A trading system that worked well in the past would soon survive any present losing streak. You shouldn’t abandon your trading idea because of a losing streak: just as you shouldn’t abandon a loving, caring, faithful, honest and humble spouse because of a mistake on their part. Someone who treated you well in the past might continue doing so in future in spite of occasional shortcomings on their part. If you abandon you good system for another, you’d soon experience drawdowns with your newly-found system; just like someone who experiences the same problem with a new mate after divorcing the former good mate.

Trading systems require extensive tests prior to being used. If you see that you’re still ahead after several weeks of practice, no matter how small the profit is, why can’t you then go live? Nothing is worse for a trader than seeing how the system performs on paper but finding that they themselves haven’t consistently implemented the trades. Your strategy is most likely to work as it did in the past. This doesn’t mean you won’t have losses; but it simply means you’ll be able to preserve your trading capital. Therefore you need to work seriously on your trading mindset rather than blaming your trustworthy system. The problem lies with the trader, not the trading system. In spite of alternating losing and winning streaks, a skilled trader remains effective because he patiently handles every situation, faithfully keeping at his trading rules in the face of occasional and transitory disappointments.

Mr. Stefan, quoted earlier, continues saying that it’s not we as individuals that control the market, but it’s the market that’s always right. All we can do is subject ourselves to the market action, but we exercise no control whatsoever… So the first step on the way to success is to accept that the trader is no superman, but just a human being with all the innate and acquired automated behavior patterns that are downright counterproductive in trading… Ultimately it’s all about recognizing and changing old behavior patterns that are either innate and\or acquired but not sensible in your trading.

You cannot control the markets but you can control your money and your risk on each and every trade that you make. Even, most good funds managers, who deliver 15 – 20% per year, are highly commendable for their results (however most traders are deluded by seminar people and deceptive marketers that they can make 15 – 20% week and go scot-free in the long run.) The whole secret to winning in the market is to lose the least amount possible when you're not right. You need to accept this fact or go do something else.

Drawdowns versus My Strategies

I’m completely aware of how drawdowns may affect each of my current 4 trading strategies and how I’ll move ahead despite these. This is revealed so that my existing and potential subscribers can better understand.

A. GBPJPY/USDCAD strategy; swing cum hedging trading (not NFA-compliant).You could get its password and login of the account on which it’s traded on request. The target profit for this year is a minimum of 2000 pips. A few considerable drawdowns are envisaged with this trading system this year, and each of it would be eventually recovered – especially with the present combination of two instruments.

B. Effective Gap Trading (NFA-compliant). The setups for this trading system are rare, but once they occur, just note that it’s time to collect money from the ATM of the financial markets. The system would be explained in the middle of February 2011, after which you could opt to have an access to the account on which it’s being traded. Risk per trade is limited to 1% while Stops are moved to breakeven wherever prices move in predefined directions. The risk-to-reward ratio is 1:2, making it possible to move ahead nicely with easily achievable 50% probability.

C. Results-oriented EURUSD-USDCHF Correlation Strategy (NFA-compliant); to be released early March 2011. This is another income-generating strategy which makes you profit regardless of the market directions and uncertainties, although there are times when trades won’t be taken... The proper use of correlation is even profit on its own! The login and password of the account on which it’s being traded would soon be made available, so that real trades can be accessed. This kind of trading idea is against what the majority of traders would like to do (remember that the majority aren’t always right). No matter what happens on the markets, the trading risk is inherently compensated for, therefore reducing the potential drawdown on each trade. Open position are smoothed whenever there’s a minimum predetermined positive difference between an open negative position and an open positive position. On demo accounts, 0.01 lots size is recommended for each $500. For live accounts, 0.01 lot size is recommended for each $1000. This ensures long-term survival on the markets.

D. Sure-fire Strategy: The minimum target with this trading strategy is 1000 pips this year. The drawdown sustained from this strategy is limited to 3% per week. Trading is stopped for the week whenever the loss reaches the predefined minimum (so that we avoid further drawdown in a bad week). If the accumulated profit is 20% and a bad trading week takes away 3%, thus reducing the profit to 17%, trading is stopped. As long as there are winnings, trading continues. This strategy is on its way to becoming a possession of each of my subscriber.

Similarly, the fact that majority of traders fail doesn’t mean that trading is a dead end activity. Traders who are successful prove otherwise. Occasional losses leading to transient drawdowns are inevitable but not insurmountable challenges in trading. The secret to success lies in developing deep love for trading and willingness to apply trading principles that work.

NB: Effective Gap Trading system would be explained in the middle of February 2011, after which you’d gain an access to the account on which it’s being traded.

In my penultimate article last year, I featured some recent trading results from Thomas Stridsman, a CTA and well-known trading systems developer). I’d like to conclude this article with more quotes from him.

1. “As far as where to enter and exit, let’s just say I strive to keep things as simple as possible… There’s no way around the fact that you’ll have to suffer through many losing trades as a trend-following trader, but in the end your patience will be rewarded.”

2. “In my experience, knowing how to trade is much more important than knowing when to trade… Then comes positive expectancy, which doesn’t mean that you should expect a positive outcome everyday and every trade, but in the long run. That’s why you need psychology first.

3. ‘Building trend-following systems that perform reasonably well is easy. Making your strategy competitive relative other good trend-following fund managers is the really hard part. This has everything to do with money management and very little to do with when you enter or exit a trade.”

Your questions and opinions are highly welcome.

Thank you.

With best regards,

Azeez Mustapha

Forex Signals Strategist, Funds Manager &Coach

Senior Analyst

FX Instructor, LLC


Yahoo! Messenger ID: saazalmu

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NB: There is risk of loss in trading, but it is possible to be a successful trader.

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